On Wednesday, September 10, 2014, Carson Block, the famous U.S. short seller and founding partner and Director of Research of Muddy Waters Research LLC, joined the Zicklin Forensic Accounting Association and Zicklin Graduate Accounting Society (ZGAS) at Baruch College for an informative and interesting discussion. Mr. Block is one of the 50 most influential people in global finance today. He discussed his background, approach to short selling, experiences with Chinese companies, some published research of Muddy Waters LLC, and his views on the capital markets, accountants, boards of directors, lawyers, market research firms and management. Following Mr. Block’s presentation, Charles Hwang, President of ZGAS, moderated an audience Q&A session.
Some highlights of the presentation were:
· In discussing his background, Mr. Block’s first piece of advice was to “be honest with yourself about what you want to do.” One should not get a job just to make money, but do something one enjoys, which leads to money.
· Having a background that is as intellectually diverse as his, wherein he attended law school and later acted as an entrepreneur and opened a storage company in China, is beneficial. Experiences such as his make better investors and provide a more critical eye. His recommendation was to never stop learning and study other areas, as he did, to become better-rounded. He also said mistakes are all right (as long as they are small), as they allow one to develop valuable skills.
· The most valuable skill he picked up in his experiences, useful for both business and personal life, was understanding people. In doing so, he could understand what other people were thinking, taking it to the next level.
· In terms of auditors, he feels they work for their clients. There are no negative consequences for audit failure, and the accounting profession fights against accountability. Big 4 firms lobby against having to disclose the names of senior audit partners in audit reports. Key audit work is often done by juniors, thus audits usually catch small frauds and not those enacted by management. In fact, only 5% of audits uncover fraud. So, an unqualified opinion is not a clean bill of health for investors. Thus, one should never discount a strange feeling about a company.
· In terms of management, they often manage on a short-term basis and are prone to financial engineering. Once CEOs are put on a pedestal, such as those at Enron, it is hard for them to come down and admit mistake or failure.
· As to Boards of Directors, they owe their position to management, often have an easy paycheck, and thus will not crack the whip on management. When Boards do independent investigations, they usually conclude that things are running as they should, because to admit things are wrong indicates they failed in their jobs. Thus, investors should take these investigations with a grain of salt.
· With respect to lawyers, clients hire and pay them. There is also the attorney-client privilege, which shields what is truly going on in the corporate world. Lawyers are often used to comply with legal requirement disclosures, and make such documents indecipherable.
· In terms of market research firms, there are loopholes in disclosure requirements in regards to their work. They are paid to do market
research studies by the firms that hire them. For instance, they value assets by the standards of such firms. This practice is particularly egregious in China.
· The backbone of fraud is often related-party transactions, and thus Muddy Waters looks for this first. Acquisitions, accounting anomalies, and a lot of goodwill are also key indicators of fraud.
· With his experiences in China, Mr. Block said “China is to stock fraud as tech is to Silicon Valley. No fraudster from China has ever been meaningfully punished for defrauding North American investors.” Further, China and the U.S. do not recognize each other’s judgments. These risks are priced into investments in Chinese companies.
· His framework for short selling is to know enough about each discipline to understand different perspectives of dissimilar people, such as attorneys and investors. He looks backwards to see if there was financial engineering. He also always asks himself whether the market has a fundamental misunderstanding of the company.
· Muddy Waters Research generates key performance indicators as building blocks to compare different businesses in research.
· In terms of Muddy Waters Research tactics: (1) He keeps management at a distance, and always reads the transcripts of a few years’ worth of corporate conference calls when examining a company. He looks, for instance, at initiatives that were mentioned and never followed up on. He is fundamentally looking to see if management is staging and managing such calls. (2) He looks for risk factors in material disclosures, because he knows lawyers are doing their job of making things indecipherable. Thus, he makes sure to read and understand the material. (3) He pays close attention to taxes, because there are often strange things occurring with tax rates in fraud situations. (4) He is critical of fair value accounting, because this method of accounting can be used to generate a positive P&L, and ultimately leaves it to management’s discretion on whether or not they will generate a profit. (5) He is very careful with respect to management estimates.
· Mr. Block is a short selling activist, and speaks out on companies. Activists basically use facts to form a conclusion and then let
markets make the decision. This is not insider trading, as short sellers put out intellectual property and opinions, and such opinions are formed by looking backwards and not inside. Most companies won’t sue short sellers for defamation in civil lawsuits because they are aware these short sellers can prove cases against them.
· Non-activist short sellers are a traditional form of short seller, and their methods vary: from “insurance,” wherein, these are
good when the market is bad and won’t go up much in a good market, to “sniper,” which are high beta, or risk, stocks.
· Short selling counterbalances bubbles (such as the Dot-com bubble) and fraud.
ZGAS Executive Board members asked a few questions during the Q&A Session:
ZGAS Executive Vice President, Sherri Zhang, posed the following question: All of your experiences make you who you are. How does your law experience help you do research in China? Mr. Block’s response: “Good question. It was immensely helpful. Investors that don’t get into the legal aspect of how companies are structured can be missing some important issues, especially in China. Reading material exhibits closely and understanding them is important, as one finds shocking things there. But it has helped me in many situations to know there was something wrong.” Mr. Block went into detail on his experience with Sino-Forest (a Chinese company).
Keren Shi, ZGAS Internal Committee of Event Planning, then asked: “How do you complete the investigations of Chinese Companies; are attorneys and accountants Chinese, and do you have partnering firms in China that do the investigations?” Mr. Block’s response: ”We have people on the ground in China, but the Ministry of State Security in China came at everyone doing due diligence, so we had to cut down our staff. Internally we have lawyers and accountants that are Chinese and travel to China, but we work with outside firms. We don’t do it openly as Muddy Waters, and pay them through another entity. This is because one of the biggest problems in this business is
that the more successful you become the more people follow you in the market, because you will move stocks.”
ZGAS President, Charles Hwang, posed the following question: What’s the toll on your life being known as a short seller? Mr. Block’s response: “I’ve gotten death threats. I often joke with my wife that it’s one of my key performance indicators.” Ultimately, though, he feels it’s all worth it because he enjoys doing this.
To listen to the entire discussion, please click here: https://baruch.mediaspace.kaltura.com/media/Muddy+Waters+101/1_oe3xmbar
For the event slides, please click here:
We hope this has been helpful. If you would like to read more on the discussion, there are a few articles that have been written about it:
New York Times: